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Social Sciencea. You expect an RFR of 10 percent and the market return (RM) of 14 percent. Compute the expected return for the following stocks, and plot them on an SML graph. StockBetaE(Ri)U0.85 N1.25 D-0.2 b. You ask a stockbroker what the firm's research department expects for these three stocks. The broker responds with the following information:StockCurrent PriceExpected PriceExpected DividendU22240.75 N48512 D37401.25 Plot your estimated returns on the graph from part (a) and indicate what actions you would take with regard to these stocks. Explain your decisions.
| a. You expect an RFR of 10 percent and the market return (RM) of 14 percent. Compute the expected return for the following stocks, and plot them on an SML graph. |
| Stock | Beta | E(Ri) |
| U | 0.85 | |
| N | 1.25 | |
| D | -0.2 |
| b. You ask a stockbroker what the firm's research department expects for these three stocks. The broker responds with the following information: |
| Stock | Current Price | Expected Price | Expected Dividend | |
| U | 22 | 24 | 0.75 | |
| N | 48 | 51 | 2 | |
| D | 37 | 40 | 1.25 |
| Plot your estimated returns on the graph from part (a) and indicate what actions you would take with regard to these stocks. Explain your decisions. |
Expert Answer
Part (a)
RFR = 10%
The market return, RM = 14%
The expected return for a stock using CAPM equation is: E (Ri) = RFR + Beta x (RM - RFR)
Please see the table below for E(Ri) of three stocks:
Stock | Beta | E(Ri) = RFR + Beta x (RM - RFR) |
U | 0.85 | 13.40% |
N | 1.25 | 15.00% |
D | -0.2 | 9.20% |
Plot on the SML is shown in the drawing on the white board.
Part (b)
Expected return as per research house = (Expected price + Expected dividend - Current price) / Current Price
- If expected return as per research house, ER > E(Ri) calculated in part (a) then the stock is undervalued and we should buy the stock.
- If expected return as per research house, ER < E(Ri) calculated in part (a) then the stock is overvalued and we should sell the stock.
Please see the table below:
Stock | Current Price | Expected Price | Expected Dividend | Expected return as per research house | E (Ri) as calculated in part (a) | Decision | Action |
CP | EP | ED | ER = (EP + ED - CP) / CP | ||||
U | 22 | 24 | 0.75 | 12.5% | 13.4% | Overvalued | Sell |
N | 48 | 51 | 2 | 10.4% | 15.0% | Overvalued | Sell |
D | 37 | 40 | 1.25 | 11.5% | 9.2% | Undervalued | Buy |
The plot is shown on the white board. U* represents the expected return as per the research house for stock U and so on....
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